After Argentina defaulted in 2001/2002, a hedge fund of Elliot Capital bought Argentinian debt at a very low fraction of par value, making about 1680% on its initial investment.
While the majority of bond holders (93%) agreed to a restructuring of the debt, the remaining 7% of investors including Elliot Capital, the holdout investors, still own the original bonds.
After years of legal disputes between Argentina and the holdout investors, a US court ruling assigns Argentina to pay the holdout investors according to the original contracts.
Another ruling prohibited Argentina from making payments to restructured bondholders if the holdout investors are not repaid as well. This was done to put pressure on Argentina to finally reach an agreement with the holdout investors.
After negotiations failed and the dispute is not settled yet, Argentina technically defaulted again by the end of July. Economists estimate that this will put Argentina’s economy in a recession with increasing unemployment, high inflation and rising interest rates.
Is it right to buy distressed credit?
The first question coming up at such a process is of course whether it is ethically right or wrong to buy distressed credit at all and speculate on a comeback of those bonds.
A first intuition might be that investors, as hedge funds in the example above, misuse the fear of bondholders in order to buy debt at prices far below their actual value.
On the other hand, there is freedom of contract. If a bondholder wants to sell his bond, he is free to do so at the current market price. If the bond recovers and the buyer makes high profits with it, then this is ethically not wrong. The seller could have held the bond as well - he just did not.
Another aspect of this question is, whether there is an effect on other participants, which are not directly included in the agreement of selling and buying the bond.
For the bond’s issuer it is irrelevant who holds the bond at a first glance. The issuer received the par value already and is still holding the same contract as before with another person.
At a second view, it may make a difference. New investors might have different intentions and the concentration of debt at a single one creates a better bargaining position, leading to the second question:
Must bondholders participate in a restructuring process?
For the investors having exposure to a defaulted issuer, the participation of every bondholder in a restructuring process is good because everyone agrees to lose a part of his investment instead of the risk to losing everything. A small proportion of holdout investors could make the restructured investors suffer as well, as the example of Argentina shows.
Furthermore, participating in a restructuring process is good of the issuer itself. Agreeing to accept a haircut in the outstanding debt and interest gives an issuer the freedom to solve underlying problems. Such may be high unemployment and low economic growth in the public sector or to low productivity at the businesses side.
From this point of view, the participation of everybody in a restructuring process is beneficial. Everybody would therefore have the ethical obligation to agree to new terms.
From another point of view, this obligation becomes questionable. In a free society, we can make contracts as we like to and expect counterparties to stick to those. If someone invests in bonds, he agrees to deliver the par value up front and the counterparty agrees to repay the par value and pay interest on it.
If a state or corporation is now unwilling or unable to service the debt, they are the ones behaving wrongfully and override the value of sanctity of contract.
According to the freedom one has within our society, an investor is now able to renegotiate the contract. But there is no obligation to do so. He is free to make a new contract, but he is also free to rely on previously made promises.
Still, there is a practical solution possible where both sides of the problem are taken into account. Contract clauses where all debt is restructured if a majority, for example two-thirds of all bondholders, agrees to the restructuring plan can be introduced. This is already done by the European Union member states.
The will to do the greater good is satisfied because the debt is restructured and gives the issuer the ability to solve structural problems while investors will at least get their investment partially back.
Freedom of contract is respected because no investor is forced to buy a bond including such a clause. The issuer is as well not to blame when restructuring. Even if not everybody agrees to it, he is just enforcing contract clauses the investors have agreed to.
Whose fault is it if an issuer defaults?
This solution has one problem: Because many existing contracts just do not have this clause, it is not always applicable. In this case, an issuer as Argentina may face the exact problem that a small proportion of holdout investors insist on getting their money back. So whose fault is the default of an issuer?
One side to blame might be the holdout investors. If they would not insist on full repayments and agree to a restructuring, the payments would not be needed to the crucial extend that ruins the issuer.
On the other hand, there is the question why such a restructuring is needed in the first place. Is it not the issuer’s fault that he did not solve his structural problems, did not spend his money right and is now unable to repay his debt? Sure it is. A country as Argentina is responsible for its economic and fiscal policy. A corporation is responsible for its costs and revenues. They must all make sure that they will finally have the money to make repayments and that no restructuring is needed at all.
Because both parties might be the ones actually causing the default of an issuer, this question might not be answered on moral grounds only but as well from the behaviour of the parties before and during the restructuring process.
In the example of Argentina, we already have an economy running at a high inflation rate and facing low growth. Now hedge funds are blamed publicly for all this by Argentina’s government and the whole issue is used as an advertisement campaign for the Kirchner administration. Therefore, we might conclude that this default is probably Argentina’s fault and just one example of the wrongful policy their government has introduced during the last years including expropriation, publishing wrongful economic data, corruption and abstraction of public funds.